Sunday, October 12, 2008

Markets Are Not Magic, by Mark Thoma: To listen to some commentators is to believe that
markets are the solution to all of our problems. Health care not working? Bring
in the private sector. Need to rebuild a war-torn country? Send in the private
contractors. Emergency relief after earthquakes, hurricanes, and tornadoes?
Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats
government every time. Or so we are told. But this is misplaced faith in
markets. There is nothing special about markets per se - they can perform very
badly in some circumstances. It is competitive markets that are magic
(though even then we have to remember that markets have no concern whatsoever
with equity, only efficiency, and sometimes equity can be an overriding
concern).

In order to work their magical efficiency, markets need very special
conditions to be present. There must be full information available to all
participants. Product quality, locations and prices of alternative suppliers,
every relevant piece of information must be known. Not quite sure if the wine is
good or not? That's an information problem. Not sure if the used car has
problems? Don't know where any gas stations are except the ones beside the
freeway in a strange town? No way to be sure if consultants are worth the amount
they are being paid? Information problems are common and they can cause
substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single
buyer or seller's decisions can affect the market price. For example, if a firm
can affect the market price by threatening to limit supply, the market does not
satisfy this condition. If, as some claim, CEOs are in such short supply that
they can individually negotiate their compensation, then the market is not
producing an efficient outcome. Whenever there are a small number of
participants on either side of the market - suppliers or demanders - this is
potentially problematic.

In order for markets to work their magic, the product must be homogeneous.
That is, the product or input to production sold by all firms in the market must
be perfectly substitutable so that as far as the buyer is concerned, one is as
good as the other. If some buyers favor one brand over another, if CEOs are
perceived to have different and unique talents, if government favors one
contractor over another due to political contributions, this condition does not
hold. In many cases the variety may be worth the inefficiency, not many of us
would want just one style and color of shirt to be available in stores, but the
inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit.
Most people understand free entry, but free exit is sometimes less evident, so
let me try to give an example. Starting a blog on Blogger or TypePad is easy.
Entry is a snap and you can be up and running in no time at all. It's easy to
join the competition and start supplying posts. But suppose that later you
decide you want to switch, say, from TypePad to Blogger. That is not so easy.
There is no way, at least no simple and convenient way, to export all of your
old posts from TypePad and import them into Blogger, a significant barrier to
exit if a large number of posts must be moved. Whenever barriers exist in
markets that prevent free movement into and out of the marketplace or between
firms within a market (on either side - there are sometimes barriers to
purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can
be no externalities, no public goods, no false market signals, no moral hazard,
no principal agent problems, and, importantly, property rights must be
well-defined (and I probably missed a few). In general, the incentives that the
market provides must be consistent with perfect competition, or nearly so in
practical applications. When the incentives present in the marketplace are
inconsistent with a competitive outcome, there is no reason to expect the
private sector to be efficient.

Markets don't work just because we get out of the way. When government
contracts are moved to the private sector without ensuring the proper incentives
are in place, there will be problems - waste, inefficiency, higher prices than
needed, etc. There is nothing special about markets that guarantees that
managers or owners of companies will have an incentive to use public funds in a
way that maximizes the public rather than their own personal interests. It is
only when market incentives direct choices to coincide with the public interest
that the two sets of interests are aligned.

If there is no competition, or insufficient competition in the provision of
government services by private sector firms, there is no reason to expect the
market to deliver an efficient outcome, an outcome free of waste and
inefficiency. Why would we think that giving a private sector firm a monopoly in
the provision of a public service would yield an efficient outcome? If the
projects are of sufficient scale, or require specialized knowledge so that only
one or a few private sector firms are large enough or specialized enough to do
the job, why would we expect an ideal outcome just because the private sector is
involved? If cronyism limits the participants in the marketplace, why would we
expect an outcome that maximizes the public interest?

There is nothing inherent in markets that guarantees a desirable outcome. A
market can be a monopoly, a market can be perfectly competitive, a market can be
lots of things. Markets with bad incentives produce bad outcomes, markets with
good incentives do better.

I believe in markets as much as anyone. But the expression "free markets" is
often misinterpreted to mean that unregulated markets are all that is required
for markets to work their wonders and achieve efficient outcomes. But
unregulated is not enough, there are many, many other conditions that must be
present. Deregulation or privatization may even move the outcome further from
the ideal competitive benchmark rather than closer to it, it depends upon the
type of regulation and the characteristics of the market in question.

When competitive conditions are not met but can be regulated, the regulations
should be put in place and the private sector left to do its thing (e.g.
mandating that sellers disclose problems with a house to prevent asymmetric
information or mandating that government funded projects be subject to
competitive bidding and monitoring to ensure contract terms are met). There's no
reason for government to do anything except ensure that the incentives to
motivate competitive behavior are in place and enforced.

But rampant privatization based upon some misguided notion that markets are
always best, privatization that does not proceed by first ensuring that market
incentives are consistent with the public interest, doesn't do us any good.
There are lots of free market advocates out there and I am with them so long as
we understand that free does not mean the absence of government intervention,
regulation, or oversight. Free means
that the conditions for perfect competition are approximated as much as possible
and sometimes that means the presence - rather than the absence - of government
is required.

As we are seeing now, sometimes markets can fail catastrophically, but that
doesn't mean that all markets fail, or that we should lose faith in the ability
of markets to allocate goods and services. Most markets work pretty well. Every day, somehow, the needs of
hundreds of millions of people are met through our market system. For the most
part, when you go to the marketplace, you can find what you want -- somehow, the
market anticipates your needs and has the goods and services ready and waiting
when you walk through the door of a store. You won't always find what you are
looking for, stores can stock out, oversupply, not have what you want, and so
on, but most of the time you do find what you are looking for, or don't have to
wait long to get it. When you think about it, it's actually pretty amazing that
we are able to coordinate so many diverse actions of so many individuals into an
economic system that does a pretty good job of providing for our needs,
responding to changes in our tastes, providing incentives for technological
advancement, and so on.

So I don't think the lesson of this crisis is that markets don't work. I
think the lesson is that markets don't always work, that we need to be vigilant
in our oversight of markets to make sure they really do satisfy, as much as
possible, the competitive ideals that are necessary for markets to perform well.

I believe that markets do have lots to offer, and I hope we don't
lose faith in the market system. But I do not believe that a
competitive marketplace necessarily evolves on its own if we simply get
the government out of the way. What market share did some of these
financial firms have? Why were they allowed to get too big and too
interconnected to fail? Why didn't we ask more questions about the
ability of ratings agencies operating as a duopoly and paid by the
firms whose securities they are rating to solve asymmetric information
problems? Shouldn't we have paid more attention to other market
failures such as moral hazard and adverse selection issues that seem to
plague all types of insurance markets, including those in financial
markets? Why didn't agency problems, a common market failure, receive
more notice and attention? And so on, and so on. Government oversight
is needed to produce and maintain a competitive marketplace,
competitive markets don't just happen through self-correction, and in a
broad sense the failure to ensure that these conditions were satisfied,
and when they couldn't be satisfied to ensure that the markets were
subjected to strict oversight to prevent exploitation of market power,
systemic breakdown, etc., is one reason we are in the mess we are in.

There's a difference between government imposing conditions on
markets that cause distortions, and oversight that maintains a stable
and competitive marketplace. Allowing markets to regulate themselves
hasn't worked, a competitive market is not an inevitable outcome of
government turning its back and saying do whatever you want, and it's
time for regulators to reassert the power they have to regulate markets
in the public interest. If we fail in our oversight of markets, if we
let markets take on non-competitive and unstable structures, then we
shouldn't be surprised when markets fail us in return.

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Regulation and Competitive Markets

I want to rerun an old post, then add something to it:

Markets Are Not Magic, by Mark Thoma: To listen to some commentators is to believe that
markets are the solution to all of our problems. Health care not working? Bring
in the private sector. Need to rebuild a war-torn country? Send in the private
contractors. Emergency relief after earthquakes, hurricanes, and tornadoes?
Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats
government every time. Or so we are told. But this is misplaced faith in
markets. There is nothing special about markets per se - they can perform very
badly in some circumstances. It is competitive markets that are magic
(though even then we have to remember that markets have no concern whatsoever
with equity, only efficiency, and sometimes equity can be an overriding
concern).

In order to work their magical efficiency, markets need very special
conditions to be present. There must be full information available to all
participants. Product quality, locations and prices of alternative suppliers,
every relevant piece of information must be known. Not quite sure if the wine is
good or not? That's an information problem. Not sure if the used car has
problems? Don't know where any gas stations are except the ones beside the
freeway in a strange town? No way to be sure if consultants are worth the amount
they are being paid? Information problems are common and they can cause
substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single
buyer or seller's decisions can affect the market price. For example, if a firm
can affect the market price by threatening to limit supply, the market does not
satisfy this condition. If, as some claim, CEOs are in such short supply that
they can individually negotiate their compensation, then the market is not
producing an efficient outcome. Whenever there are a small number of
participants on either side of the market - suppliers or demanders - this is
potentially problematic.

In order for markets to work their magic, the product must be homogeneous.
That is, the product or input to production sold by all firms in the market must
be perfectly substitutable so that as far as the buyer is concerned, one is as
good as the other. If some buyers favor one brand over another, if CEOs are
perceived to have different and unique talents, if government favors one
contractor over another due to political contributions, this condition does not
hold. In many cases the variety may be worth the inefficiency, not many of us
would want just one style and color of shirt to be available in stores, but the
inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit.
Most people understand free entry, but free exit is sometimes less evident, so
let me try to give an example. Starting a blog on Blogger or TypePad is easy.
Entry is a snap and you can be up and running in no time at all. It's easy to
join the competition and start supplying posts. But suppose that later you
decide you want to switch, say, from TypePad to Blogger. That is not so easy.
There is no way, at least no simple and convenient way, to export all of your
old posts from TypePad and import them into Blogger, a significant barrier to
exit if a large number of posts must be moved. Whenever barriers exist in
markets that prevent free movement into and out of the marketplace or between
firms within a market (on either side - there are sometimes barriers to
purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can
be no externalities, no public goods, no false market signals, no moral hazard,
no principal agent problems, and, importantly, property rights must be
well-defined (and I probably missed a few). In general, the incentives that the
market provides must be consistent with perfect competition, or nearly so in
practical applications. When the incentives present in the marketplace are
inconsistent with a competitive outcome, there is no reason to expect the
private sector to be efficient.